A New Paradigm
Using blockchain technology enables us first to comply with and improve on, and then to transform, the bond process.
“We kept seeing this problem over and over again in managing capital supply. We tried, but the best in banking and investment could not solve it. So, we had to find partners who could work with us, to look and consider it in an entirely new way, and then create an entirely new way! We were just ahead of our time and needed DeFi to grow into the undeniable global financial market it has become - we just wish this was already an option almost 2 decades ago!"
CEO MIRIS AS
In thinking about achieving the objectives of bond issuance in a new way, it is important to consider the origin and objective of each of the steps at each stage. There is a set of fundamental purposes to any product or activity, and the process of reinvention requires that we understand those fundamentals before we start to innovate. If this thinking doesn’t happen up front, then what tends to happen is that we recreate systems and processes that should not exist anymore. Think about music: artists still release “albums” of about a dozen songs, because when the equivalent work was produced on 78rpm records, it was sold as an album of discs bound in book form. These had in turn appropriated the term from bound albums of sheet music from the nineteenth century, but we have carried these conventions forward to the age of Spotify. When we are creating something new, we should also ensure that we are not fixing what is not broken. Looking at music again: many people feel that the sound from a vinyl record has a warmth that digital versions lack, illustrating the trade-offs in the process of innovation. When we make changes to something, it is vital to understand fully what we are changing, why it must be changed, and what we are gaining and losing in the process. In the case of creating a bond on a blockchain, we are introducing a technology that enables us to achieve the original aims in a new way, and also allows us to do things that we could not do previously. The structure of the bond process has progressed from the Mesopotamian stone, to paper certificates with coupons, to dematerialisation. The next step, given the developments in relevant technology, is the enticing possibility of creating a corporate bond as a blockchain based token, and the potential such tokens hold for further innovation.
Roles of the Parties
In looking at a new structure for corporate bonds, we consider the needs of the various parties involved, from first principles. The bond issuer wants to raise finance at low cost and low risk, and preferably quickly. The buyer is acquiring an interest income for a fixed term, and also wants to minimise costs and risks.
The third parties in the process are where the key opportunities for change lie:
- Regulatory authorities want assurance that regulations are being adhered to, and that they are able to monitor transactions as necessary;
- Brokers want to be paid for facilitating the bond transaction;
- CSDs want to be paid for providing the market trading and custody infrastructure;
- Banks want to be paid for transferring funds between parties.
In a blockchain based structure, the value added by many of these third parties is provided by the blockchain’s features. Specifically:
- The regulator knows that only verified parties are able to transact on the blockchain with these instruments, and that some rules may also be built into the blockchain through smart contracts. For the observer aspect of the role, the right permissions will allow the regulator to view transactions - and match public unidentifiable information with private information to identify each specific actor;
- The broker’s intermediary role is removed, since the transaction happens between two parties within the blockchain system (“on chain”), facilitated by technology. (The broker may, however, still play a matchmaker role - making a buyer aware of the opportunity to purchase the bond - and thereby still earn a commission on the trade);
- The CSD role is expected to evolve into, or be replaced by, the provider of blockchain infrastructure or smart contracts. This role may include securities storage in the form of custodial wallet infrastructure and other interfaces to the market to record changes in ownership;
- The bank’s role is restricted to the initial sale of tokens: once the value is on chain, then transactions do not require banking rails, or custodianship in the traditional sense.
Accepting that this digital tokenised bond is a desirable outcome, the question then becomes how we achieve this. The overriding purpose from the issuer’s perspective is to raise capital to fund operations, but a tokenised bond creates many potential enhancements to this outcome. Considering the steps of the traditional bond issuance process, where does it make sense to replace the original process, and where should we build on the system that has worked well in the past?
At its most basic level, we could simply tokenise the current process: replacing the existing ledger and certificates with a blockchain and tokenised versions of the bonds. At the other end of the spectrum is a fully digital process which creates new possibilities but may introduce new risks. The process of adoption of a new technology usually begins with applying it to the old model to achieve gains in efficiency or utility. This approach also helps incumbents to become more comfortable with the technology, and to smooth the path to more transformational work. The path to digital music began with digitising LPs onto CDs, before we ended up at Spotify. In the long term, we want to reinvent the entire bond process using blockchain tools, but our starting point is to make more incremental improvements. There must be tangible improvements, though; we want to make the minimum changes necessary to enable the most desirable features of a blockchain based system, while building on top of the well-established practices that have developed over time to manage the process.
Below we consider potential improvements that could come from a blockchain based infrastructure.
Improvements of the New Model
We look at the improvements from two perspectives. The first is with reference to the current paradigm: how does the blockchain version improve on the things that the original version did? Secondly, and more significantly, we look at the new things that are enabled because we have built a blockchain based bond: the utility that was simply not previously available. These improvements come as a benefit of the blockchain based bond environment, and as secondary benefits that a bond token brings.
With Reference to the Original Paradigm
Viewing the new blockchain based model through the traditional lens of the bond issuance and transaction processes, we can see advantages compared to the original paradigm. Moving the processes to a blockchain solves a lot of the problems with the existing approach.
- The blockchain on which the asset is captured becomes the record of ownership as well as the means of transfer of the asset, therefore reconciliation is either eliminated or made much faster and more transparent;
- The need for multiple systems and intermediaries is reduced dramatically, with a resulting reduction in the costs of errors, reconciliation, and slow processing;
- The speed of transactions, and the atomic delivery versus payment reduces settlement and counterparty risk and reduces the cost of credit;
- The nature of the blockchain provides for transparency and a clear audit trail of the bond’s history.
Many of the above benefits come because the bond is now traded across a single shared ledger, viewable - with appropriate privacy and security restrictions - to all parties. This represents a significant improvement on the many private ledgers previously used, and is a key enabling factor.
Blockchain Derived Gains
Given the transformational nature of the change to a blockchain based model, it would be missing the point to think only about improvements in terms of the old model. These are operational gains. Moving to a blockchain infrastructure creates a collection of new possibilities that did not exist before; these are strategic gains.
Some of these are just beginning to be explored, while others are well established. When taken as a whole, the features of the blockchain environment outlined above, and the bond existing as a native digital asset, enable further benefits that will accrue to both the issuer and the investor;
- A digital asset may be subdivided (fractionalised) much more economically, potentially enabling many smaller investments rather than fewer larger ones, and creating a bigger pool of potential investors;
- Interest payments can be automated and made more frequently (as often as every second) so that the bond’s value always reflects the full interest to date;
- The investor gets liquidity in the bond holding from the liquidity enabled by the bond tokens, giving finer control over the exposure to any given bond;
- The issuer has cheaper access to finance because of the efficiency of the process, and can buy or sell its own debt from and to the market respectively, thus adjusting debt exposure as and when required;
- It is much cheaper for the issuer to reissue debt in the event that more working capital is required in future;
- Finally, the investor has the potential ability to take his token and use it in DeFi as collateral to earn interest without risking the capital.
The above benefits are explained through the real example that we walk through below.